Choosing a Tax Classification for an LLC

Last Updated: 2/15/24

Aside from limited liability, another major benefit of choosing a limited liability company (LLC) as your business entity is the ability to choose your LLC tax classification. With LLCs, you can decide on your taxation method based on factors such as your goals, business size, and financial plans. Let’s take a look at each federal tax classification for LLC. 

This guide will provide information on how to choose your LLC tax status. However, it’s best to consult a tax professional and do some careful research because, once you set your tax status, you generally have to wait five years before changing it again.

Types of Tax Classification for an LLC 

An LLC, as a business structure, is designed to be flexible. This flexibility is also applied to LLC tax classifications. In selecting your LLC tax status, you can choose one of these tax structures: 

• Disregarded entity 
• Partnership 
• Corporation (either C corp or S corp) 

By default, LLCs are classified based on the number of members (owners). A single-member LLC is treated as a sole proprietorship and classified as a “disregarded entity” by the IRS, while a multi-member LLC is taxed as a partnership. Either as a sole proprietorship or a partnership, LLCs are treated as a “pass-through” entity unless they choose to be taxed as a C corporation.

Being a pass-through entity means that the business itself typically doesn’t pay federal income tax on its profits. The responsibility to pay income taxes falls only on the individual owner(s). This is unlike a typical corporation, in which profits are taxed at both the business level and the individual business owner level.

However, an LLC can also choose to be taxed as a corporation. This option is available to both a single-member LLC and a multi-member LLC. Now, this doesn’t change the business structure from an LLC to a corporation. It just dictates how the LLC will be treated for tax purposes. 

If you choose to have your LLC taxed as a corporation, you have two options: being taxed as a C corporation (the default form of corporation) or an S corporation. There are very important distinctions between a C corp and an S corp, which we’ll explain later. 

How to Choose Your Tax Status 

Here’s a step-by-step guide to consider when choosing your LLC tax status. 

• Determine whether your LLC will be taxed as a sole proprietorship, partnership, S corporation, or C corporation. 

• Consider all the factors for each tax status, factors like financial implications, administrative requirements, and ownership restrictions. 

• Consult with a licensed tax professional to ensure the chosen tax status is the most beneficial for your specific situation. 

• If filing as a corporation, file the appropriate forms with the IRS to elect your LLC’s tax status.

What is the best tax classification for an LLC?

As stated earlier, the major factors most entrepreneurs consider before settling for a tax classification for their LLC include business size, financial plan, and overall members’ goals. So keep those in mind as we briefly discuss each tax classification and the business setup they’re each suited for. 

Disregarded Entities 

Disregarded entities are the simplest tax classification with straightforward tax reporting. Your LLC is not taxed or required to file a tax return. Instead, the business profits and losses pass to you as the sole owner to be reported on your personal income tax return. For a single-member LLC just starting, it’s often safe to begin with this tax status. 

The downside to this tax classification or the partnership classification is that the owner is responsible for paying self-employment tax. The self-employment tax rate is 15.3% and will be reported in addition to income taxes. Self-employment taxes are the taxes that go toward Social Security and Medicare.

Partnerships 

The partnership tax classification is quite similar to that of the disregarded entity, except that it’s for LLCs with multiple members. It’s a simple and effective tax structure, which is ideal for a multi-member LLC starting out. 

Like a sole proprietorship, the partnership is treated like a pass-through entity, and its members can avoid the “double taxation” of a corporation, in which profits are taxed at both the business and individual owner levels. However, this tax arrangement can prove problematic for LLCs with passive members. This is because each member is responsible for income tax on their portion of the LLC’s revenue, even if they don’t receive distributions. 

S Corporations 

The S-corp tax structure is not applied by default; business owners have to elect to change their default classification by filing Form 2553. To qualify for S corporation status, an LLC must meet the following requirements, which include having:

• Only U.S. members, which can be individuals, certain trusts, and estates
• No members that are partnerships, corporations, or non-resident aliens
• No more than 100 members

An LLC with an S-corp tax classification will not pay federal income tax itself but must file tax Form 1120-S every year. Form 1120S is the U.S. Income Tax Return for an S-Corp. 

Why would an LLC choose S corp status?

Even though a traditional LLC already has pass-through taxation, it could still benefit from electing S corp status. It takes a bit of explanation, but it could mean substantial tax savings for some LLCs.

The members of a standard LLC are considered self-employed. They’re compensated by receiving their share of profits from the LLC, but they can’t be employed by the LLC. Being self-employed means you will pay self-employment taxes (the taxes earmarked for Social Security and Medicare, which add up to about 15.3%) on all profits they receive from the LLC. This is more than the taxes they’d pay when working for someone else because their employer would pay half of them.

When the members elect S corp status, though, they can be compensated in two ways, by receiving their share of the profits and by being paid as an employee. Once they do that, they only pay employment taxes on their salary and not the profits they receive. (Of course, this is only for the taxes that go toward Social Security and Medicare; LLC members still must pay income and other applicable taxes on their profits.) 

Disadvantages to S Corporation Election for LLCs

One caveat to this is that the IRS expects you to pay yourself a “reasonable salary” as an employee of the LLC. Otherwise, you could pay yourself an annual salary of $1 and avoid contributing anything to Social Security and Medicare. The IRS doesn’t give a precise definition, but it seems to consider “reasonable” to be something similar to what others in your field are earning for the same work.

Another disadvantage to S corporation election is that you’ll need to do payroll for yourself and the other members. If you don’t already have employees you’re doing payroll for, this will be a significant extra hassle and/or expense, depending on whether you do payroll yourself or pay someone else to do it.

C Corporations 

If you choose to be taxed as a C corporation (the default form of corporation), you’ll be taxed twice on your profits — once at the entity level (when the business must pay corporate income tax) and then at the individual level when you file your personal tax returns. Despite this double taxation, certain LLCs may benefit from this tax structure, as it has the most possible deductions. For example, C corporations may be able to deduct the cost of insurance premiums for employees.

LLCs that elect to be taxed as a C-corp must file Form 8832 with the IRS.

We can help!

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Disclaimer: The content on this page is for information purposes only and does not constitute legal, tax, or accounting advice. If you have specific questions about any of these topics, seek the counsel of a licensed professional.